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More IRS Regulations On Qualified Opportunity Zones

Skyscraper Buildings Made From Dollar Banknotes

The IRS just issued more proposed regulations under §1400Z-2 of the Internal Revenue Code, dealing with investments in qualified opportunity zones and qualified opportunity funds. Some highlights:

  • In general, a QOF must spend at least as much to rehabilitate a building as it paid for the building itself. But this rule doesn’t apply to a building that’s been vacant for five years. This presents an enormous incentive to acquire and rehabilitate vacant properties (that are located in QOZs).
  • The tax benefits associated with QOFs are available only to an “active trade or business.” The new regulations provide that (1) the ownership and operation (including leasing) of real estate can qualify as an “active trade or business,” for these purposes, but (2) a triple-net lease of real estate is not an “active trade or business.”
  • To qualify for tax benefits, a corporation or partnership must derive at least 50% of its gross income from the active conduct of a business within a QOZ. The new regulations provide three safe harbors and a facts-and-circumstances test to make this 50% calculation.
  • In general, at least 90% of the assets of a QOF must be in the form of “qualified opportunity zone property.” The new regulations allow the QOF to ignore investments made by investors in the QOF during the preceding six months in making this calculation, as long as the new investments are held in cash, cash equivalents, or certain short-term debt instruments This rule will make it far easier for QOFs to satisfy the 90% test while continuing to raise capital.
  • Similarly, if a QOZ sells assets and reinvests the proceeds in other assets, then the proceeds of the sale will be treated as “qualified opportunity zone property” for purposes of the 90% test, as long as they are held in cash, cash equivalents, or certain short-term debt instruments and reinvested within 12 months. Of course, any gain recognized by the QOZ from the sale will be taxed to investors.
  • The new regulations provide that an investment in a QOF may be made with cash or other property, but not by performing services for the QOF.
  • The new regulations provide alternative approaches to valuing the assets of a QOF, both for making the 90% calculation and for determining whether substantially all of the QOFs assets are in a QOZ.
  • A “qualified opportunity zone business” must own “qualified opportunity zone property,” and “qualified opportunity zone property” does not include property purchased from a related party. But under the new regulations, it can include property leased from a related party, under certain circumstances.
  • By investing in a QOF, a taxpayer can defer recognizing capital gains for tax purposes until 12/31/2026. But if an “inclusion event” occurs before 12/31/2026, the taxpayer must recognize the capital gain at that time. Selling the interest in the QOF is an obvious example of an “inclusion event.” The new regulations provide many more, less obvious examples, like giving the interest in the QOF to a charity, or receiving a distribution from the QOF that exceeds the taxpayer’s basis.
  • After holding a QOF for 10 years, a taxpayer may exclude all capital gains from the appreciation of the interest in the QOF. The new regulations provide that the taxpayer doesn’t have to sell her interest in the QOF to benefit from the exclusion; the exclusion also applies if the QOF sells its assets and distributes the gains.
  • A ”qualified opportunity zone business” means a trade or business in which substantially all of the tangible property is “qualified opportunity zone business property.” The new regulations clarify that in this instance, “substantially all” means 70%.
  • “Qualified opportunity zone business property” means tangible property used in the trade or business of the QOF if, during substantially all of the QOF’s holding period for such property, substantially all of the use of the property was in a QOZ. Believe it or not, the new regulations provide that the first instance of “substantially all” in that sentence means 90% and the second instance means 70%.

The new regulations illustrate why tax lawyers so look forward to new tax legislation, and are so popular at cocktail parties.

Questions? Let me know.

The IRS Regulations on Qualified Opportunity Zone Funds

Qualified Opportunity Zone Funds

The Internal Revenue Service just issued regulations about qualified opportunity zone funds, answering many of the questions raised by the legislation itself. And for the most part, the answers are positive for investors and developers.

Can I Use An LLC?

Yes. Although the legislation provides that a QOZF must be a “corporation or a partnership,” the regulations confirm that a limited liability company treated as a partnership for tax purposes (or any other entity treated as a partnership for tax purposes) qualifies.

How Do I Calculate Rehabilitation Costs?

To qualify as “qualified opportunity zone business property,” either the original use of the property must begin with the QOZF or the QOZF must “substantially improve” the property. The statute says that to “substantially improve” the property, the QOZF must invest as much in improving the property as it paid for the property in the first place.

The regulations carve out an important exception: in calculating how much the QOZF paid for the property, the QOZF may exclude the cost of the land. Thus, a QOZF that buys an apartment building for $2,000,000, of which $1,500,000 was attributable to the cost of the land, is required to spend only $500,000 on renovations, not $2,000,000.

What Kind of Interest Must an Investor Own?

To obtain the tax deferral, an investor must own an equity interest in the QOZF, not a debt instrument. Preferred stock is usually treated as an equity interest.

Are Short-Term Capital Gains Covered?

Yes, all capital gains are covered. Ordinary income — for example, from depreciation recapture — is not.

Do All The Assets of the Business Have to be in the Qualified Opportunity Zone?

A business can qualify as a “qualified opportunity zone business” only if “substantially all” of its tangible assets are located in the qualified opportunity zone. The regulations provide that “substantially all” means at least 70%. That means that 30% of the assets of the qualified opportunity zone business can be outside the qualified opportunity zone.

NOTE:  Don’t get confused. To qualify as a QOZF, the fund itself must have invested 90% of its assets in “qualified opportunity zone property.” One kind of of “qualified opportunity zone property” is a “qualified opportunity zone business.” The 70/30 test applies in determining whether a business is a “qualified opportunity fund business.” So if a QOZF owns assets directly, 90% of those assets must be in the qualified opportunity zone. But if the QOZF invests in a business, then only 70% of the assets of the business must be in the qualified opportunity zone.

NOTE:  Many QOZFs will own property through single-member limited liability companies. When applying the 70% test and the 90% test, bear in mind that a single-member limited liability company is generally not treated as a “partnership” for tax purposes, but rather as a “disregarded entity.” For tax purposes, assets owned by the single-member limited liability company will be treated as owned directly by the QOZF.

What Happens in 2028, When the Program Ends?

The qualified opportunity zone program ends in 2028. Nevertheless, the regulations allow investors to continue to claim tax benefits from the program until 2048.

How Long can the QOZF Wait to Invest?

Suppose a QOZF raises $5M today. When does the money have to be invested?

The regulations provide that under some circumstances, you can wait up to 31 months to invest. But this is one area where more guidance is needed.

Questions? Let me know.

Improving Legal Documents in Crowdfunding: New Tax Audit Language for Operation Agreements

 

By: Steve Poulathas & Mark Roderick 

Last year I reported that Congress had changed the rules governing tax audits of limited liability companies and other entities that are treated as partnerships for tax purposes. The changes don’t become effective until tax years beginning on or after January 1, 2018, but because most LLCs created today will still be around in 2018, it’s a good idea to anticipate the changes in your Operating Agreements today.

Under the current rules, the IRS conducts audits of LLCs at the entity level through a “tax matters partner” (normally the Manager of the LLC), and collects taxes from the individual members. Under the new rules, the IRS will continue to conduct audits at the entity level, but will also collect taxes, interest, and penalties at the entity level. That puts the LLC in the position of paying the personal tax obligations of its members, a drain on cash flow every deal sponsor will want to avoid.

Naturally, there are exceptions to the new rules and exceptions to the exceptions. Trouble sleeping? I’ll send you a detailed summary.

Consult with your own tax advisors, of course, here’s some language for your Operating Agreements that gives the deal sponsor maximum flexibility:

Tax Matters.

  1. Appointment. The Manager shall serve as the “Tax Representative” of the Company for purposes of this section 1. The Tax Representative shall have the authority of both (i) a “tax matters partner” under Code section 6231 before it was amended by the Bipartisan Budget Act of 2015 (the “BBA”), and (ii) the “partnership representative” under Code section 6223(a) after it was amended.
  2. Tax Examinations and Audits. At the expense of the Company, the Tax Representative shall represent the Company in connection with all examinations of the Company’s affairs by the Internal Revenue Service and state taxing authorities (each, a “Taxing Authority”), including resulting administrative and judicial proceedings, and is authorized to engage accountants, attorneys, and other professionals in connection with such matters. No Member will act independently with respect to tax audits or tax litigation of the Company, unless previously authorized to do so in writing by the Tax Representative, which authorization may be withheld by the Tax Representative in his, her, or its sole and absolute discretion. The Tax Representative shall have sole discretion to determine whether the Company (either on its own behalf or on behalf of the Members) will contest or continue to contest any tax deficiencies assessed or proposed to be assessed by any Taxing Authority, recognizing that the decisions of the Tax Representative may be binding upon all of the Members.
  3. Tax Elections and Deficiencies. Except as otherwise provided in this Agreement, the Tax Representative, in his, her, or its sole discretion, shall have the right to make on behalf of the Company any and all elections under the Internal Revenue Code or provisions of State tax law. Without limiting the previous sentence, the Tax Representative, in his, her, or its sole discretion, shall have the right to make any and all elections and to take any actions that are available to be made or taken by the “partnership representative” or the Company under the BBA, including but not limited to an election under Code section 6226 as amended by the BBA, and the Members shall take such actions requested by the Tax Representative. To the extent that the Tax Representative does not make an election under Code section 6221(b) or Code section 6226 (each as amended by the BBA), the Company shall use commercially reasonable efforts to (i) make any modifications available under Code section 6225(c)(3), (4), and (5), as amended by the BBA, and (ii) if requested by a Member, provide to such Member information allowing such Member to file an amended federal income tax return, as described in Code section 6225(c)(2) as amended by the BBA, to the extent such amended return and payment of any related federal income taxes would reduce any taxes payable by the Company.
  4. Deficiencies. Any deficiency for taxes imposed on any Member (including penalties, additions to tax or interest imposed with respect to such taxes and any taxes imposed pursuant to Code section 6226 as amended by the BBA) will be paid by such Member and if required to be paid (and actually paid) by the Company, may  be recovered by the Company from such Member (i) by withholding from such Member any distributions otherwise due to such Member, or (ii) on demand. Similarly, if, by reason of changes in the interests of the Members in the Company, the Company, or any Member (or former Member) is required to pay any taxes (including penalties, additions to tax or interest imposed with respect to such taxes) that should properly be the obligation of another Member (or former Member), then the Member (or former Member) properly responsible for such taxes shall promptly reimburse the Company or Member who satisfied the audit obligation.
  5. Tax Returns. At the expense of the Company, the Tax Representative shall use commercially reasonable efforts to cause the preparation and timely filing (including extensions) of all tax returns required to be filed by the Company pursuant to the Code as well as all other required tax returns in each jurisdiction in which the Company is required to file returns. As soon as reasonably possible after the end of each taxable year of the Company, the Tax Representative will cause to be delivered to each person who was a Member at any time during such taxable year, IRS Schedule K-1 to Form 1065 and such other information with respect to the Company as may be necessary for the preparation of such person’s federal, state, and local income tax returns for such taxable year.
  6. Consistent Treatment of Tax Items. No Member shall treat any Company Tax Item inconsistently on such Member’s Federal, State, foreign or other income tax return with the treatment of such Company Tax Item on the Company’s tax return. For these purposes, the term “Company Tax Item” means any item of the Company of income, loss, deduction, credit, or otherwise reported (or not reported) on the Company’s tax returns.

Questions? Let us know.

 

Steve Poulathas is member of Flaster Greenberg’s Taxation, Business and Corporate, Trusts and Estates and Employee Benefits Practice Groups. He counsels and represents individuals, family-owned businesses and public companies in the tax, business and finance, and estate practices. He can be reached at 856.382.2255 or steve.poulathas@flastergreenberg.com.

 

 

Mark Roderick is one of the leading Crowdfunding lawyers in the United States. He represents platforms, portals, issuers, and others throughout the industry. For more information on Crowdfunding, including news, updates and links to important information pertaining to the JOBS Act and how Crowdfunding may affect your business, follow Mark’s blog, or his twitter handle: @CrowdfundAttny. He can also be reached at 856.661.2265 or mark.roderick@flastergreenberg.com.

 

Improving Legal Documents in Crowdfunding: New IRS Audit Rules

In the Crowdfunding world, almost every equity investment involves a limited limited liability company. Because (1) limited liability companies are treated as partnerships for tax purposes, and (2) Congress has just turned the law governing tax audits of partnerships on its head, all those LLCs will need to revise their Operating Agreements. And all new LLCs will have to follow suit.

Until now, tax disputes involving partnership were conducted at the partner level. That means the IRS had to pursue partners individually, based on each partner’s personal tax situation. With its budget cut and manpower reduced, the IRS was unable to pursue everybody.

Seeking to streamline partnership audits and ultimately collect more taxes, the (bipartisan) law just passed reverses that rule.  Now, the IRS conducts audits at the partnership level and no longer has to argue with all those partners and their accountants. In fact, even though partnerships are not normally subject to tax, under the new law the partnership itself must pay any tax deficiency arising from the audit, unless it makes a special election.

EXAMPLE: NewCo, LLC owns an apartment building. The IRS decides NewCo used the wrong method of depreciation, and adds $1 million to NewCo’s taxable income. Under the new law, NewCo itself is liable for tax on $1 million, calculated at the highest possible tax rate. However, NewCo may elect to make its members personally liable instead.

Under old law, every partnership had a “tax matters partner” with broad administrative responsibilities. The new law creates a much more powerful position, the “partnership representative,” with the power to bind the partnership and all of its partners on tax matters. The partnership representative doesn’t even have to be a partner, just a person or entity with a substantial U.S. presence:  an accounting firm, for example.

The law becomes effective in 2018. Between now and then, all existing limited liability companies should revise their Operating Agreements to:

  • Provide whether taxes due as a result of tax return audit will be paid at the partnership or partner level
  • If the tax is paid at the partnership level, how the economic cost will be shared by the partners
  • Designate a partnership representative
  • Describe the duties and powers of the taxpayer representative, within the statutory limits
  • Describe the obligations of the partnership and partners to share tax-related information

Obviously, all new limited liability companies should deal with those issues at the outset.

Questions? Let me know.

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